Goodwill Allocations and Their Importance

In accounting, “goodwill” makes a business more than a collection of assets such as real estate, equipment, inventory, receivables, and cash. This intangible value can stem from the practitioner (personal goodwill) or the practice (enterprise goodwill).
Personal goodwill is the intangible value of earnings or cash flow directly attributed to an individual’s characteristics or attributes (new and repeat business comes from the draw of the clinician). Enterprise (dental practice) goodwill is the value of earnings or cash flow directly attributed to the business’s characteristics or attributes (earnings are acquired from those who patronize the business as opposed to the individual).

The Importance of Goodwill and its Attribution
Deciding if goodwill value will be allocated to the dental practice or to the owner(s) is crucial. An inaccurate or careless apportionment can mean the difference between substantial monies in a practice valuation and transition or diminished borrowing capacity. The valuation process in determining where the goodwill value is reported can affect how the practice owner lives the rest of her life.
Dental practices and the individual practitioner typically have an allocation of goodwill equal to more than 70% of the value of the total assets, including the physical assets. This is unlike other businesses where the tangible business assets are worth more than the intangibles. When assessing a practice, a lender looks to the goodwill allocation more so than to any other asset. Lending to dentists is not typically collateralized in the same way as a manufacturer, for example, where inventory is available to be placed as security.
The value of goodwill can be distributed in different scenarios. Some examples, which are addressed below, are divorce proceedings, income tax allocations, damage claims, and partnership and shareholder disputes.

Goodwill Allocation and Divorce
In some states during divorce proceedings, the goodwill allocation between the dental practice and the personal goodwill of the dentist represents what value is available value to the spouse or what remains for the dentist. In many divorce cases, this difference can mean thousands of dollars.
There are a number of attributes that I use to allocate how much each spouse contributes to the dental practice. This dollar amount is presented to court to help determine what is available for the non-dental spouse from the value of the dental practice. The amount of effort and sometimes money contributed by the dental spouse, considered personal goodwill, is not available for distribution to the non-dental spouse. You can see how significant the allocation becomes to the dentist and spouse in a case such as this. 

Goodwill Factors and Damage Claims
I recently represented a dentist with a large practice who was involved with a damage claim against his partners. The partners argued that the value of the goodwill—which was extremely high—was all attributed to the dental practice. I assisted my client in presenting a large amount of the goodwill should be allocated to him. The amount involved was close to $1,000,000.
When determining the allocation and to which entity it belonged, I used specific and objective guidelines that allowed me to prepare for court by asking questions of employees and owners, examine the work habits of my client, and review the client’s financial statements and production reports, etc. Upon my presentation, the case ended with a settlement—an outcome that is always better than going to court, where time, money, and revenue are lost. 

Partnership and Shareholder Disputes
A final example of goodwill allocations that I will discuss involves partnership and shareholder disputes. Similar to the previous example, the amount to be awarded to a partner or shareholder upon her exit from the dental practice will cause the dentist or the dental enterprise to be the holder of the goodwill and its value.

Income Tax Allocations of Goodwill
Another factor to consider with goodwill allocation is the tax implications. One tax advantage of an allocation of goodwill to a seller of a dental practice is that it’s almost always considered a capital gain. The buyer of the goodwill does receive a tax write-off, but over a 15-year term. The challenge for the seller is from which taxable entity can the goodwill be allocated? Is there justification for allocating the sale of goodwill to the dental practice or to personal goodwill?
Besides the instant potential capital gain, think of an individual with large capital loss “carry forwards” that are suspended because of the annual loss limitation for an individual. A large capital gain classified as personal goodwill may save thousands of dollars by offsetting it against the suspended losses that have been suspended, which may otherwise take years to use.
Also, factors such as whether the dental entity is a C corporation, LLC, LLP, S corporation, or proprietorship tests the legality of allocating the goodwill between the entity and the individual. It is probable that a C corporation with an employment agreement for the practice owner/dentist of the corporation will lose the ability to allocate to goodwill to the personal account. Other entities typically don’t have this drawback because they are considered “flow through.”

Final Thought
Many factors determine where the goodwill is allocated. There are months or years of planning that go into this, requiring the dentist to follow specific guidelines, so she may build a case that will allow her to keep the goodwill where she wants it. A dental CPA is an important resource for the planning stages, and can help with continuing to adjust those areas needed to maintain the goodwill in its appropriate proportion.

About the Author
Bruce Bryen is a certified public accountant with more than 40 years of experience. He is the principal in the firm of RKG Tax and Business Services, LLC, located in Fort Washington, Pennsylvania. Mr. Bryen specializes in retirement planning design, income and estate tax planning, determination of the proper organizational business structure, asset protection, and structuring loan packages for presentation to financial institutions. For more information, please visit www.rkgcpa.com.